Pages

FPM Moot-Points:

Tweet Me Please!

Wednesday, 19 September 2012

Product Convergence or Incestuous Orgy in Alternatives - Part 2

The growth spurt
in alternatives partly reflects the flow
in capital to alternative managers from traditional ones, for various
reasons diacussed below. Accepting plutocratic model of society, traditional manager’s time-vested
and relationship-nested model of conducting a socio-politico driven economy is perhaps
on the wane in its creative-destruction cycle. As an example, I am thinking of Fidelity Investment’s
non-vogue long-only-securities investing since starting in 1946. Yet Fidelity
is still the second largest mutual fund company in the US. In Europe,
“Foreign and Colonial” a.k.a. F&C Asset Management plc, the world’s oldest
manager of mutual funds, has seen its listed share price fall to a quarter of
its value in 2000.FPM believe innovation in the securities management industry with the
newer mutual-fund models of Vanguard Group established in 1976, and the best of
breed alternative-managers like Bridgewater, formed in 1975, are bellwethers. Additionally,
lets not forget that the traditional brokers and manager’s spawned or
trans-mutated into hedge funds and private equity. The ‘hedgies’ tended to be
from the broking and agency or prop-trading side (secondary markets), while the
corporate finance or investment bank teams did the transactions (primary
markets), akin to PE-model. The closing yet untenable link between PE and hedge
funds via their cross-holding ownership yet again inexorably questions Chinese
walls issues. Our premise that
creative-destruction via alternative assets is foreboding or to be emphatic,
ill-auguring; and ultimately beneficial for FMTs.

By sampling the Carlyle Group's fund
manager transactions, as one of the world's largest connected private
equity investors, FPM believes their deals serve as a case study of ‘alternatives’
trends and consequences.

Double Click to Enlarge Image

In literary terms we think The Carlyle Group’s [CG] activity represents Jacob Marley’s ghosts showing Ebenezer Scrooge things that
have been in the past, are currently and will come to pass. Carlyle’s activity
in asset management deals are complex if not opaque beyond the reported details. For
instance, it is difficult to distinguish between their strategic and financial investment
rationale for partnerships, despite rules of thumb about <20 being="being" financial="financial">30% being strategic investments.20>

Also weaving an entangled web to the already complex
association of cross-holdings between asset managers, is through investments
in the hedge fund and/or private equity fund (i.e. via LP shares of the fund).
So we are now doubled up on exposure to GP stake and LP stake. For example, as
cited in Carlyle’s activity table above, the sovereign fund of Abu Dhabi’s Mubadala Development
Company also committed $500 mn
to an investment fund managed by Carlyle. While the US$1.85 bn of capital
involved in this particular investment is not suggestive of absolute
catastrophe to Mubadala, yet considering the aggregated capital investment of
other petro-dollar earning countries in the Middle-East region in global financial
services, the impact maybe significant
wealth destruction! The prototype for which has been set since the 2008
financial crisis. The illustrious manager of Pimco’s bonds funds, Mr William Gross,
stated that on a long-term basis,
governments are likely to use financial repression, where the rate of
inflation is higher than bond yields, to erode the value of sovereign debt over
time. The late great Barton Biggs also stated in Mid-2011 that debt devaluation via inflation
is less painful than capital destruction as a long-term course. (A prophetic Barton Biggs interview)

The
cross-holding in financial services, which is rhetorically seen as
diversification benefits (and realistically, recycling of petro-dollar revenues
etc) can insidiously become risky over-concentration
in a financial assets. For example, the overall leverage Company A states
on its books can multiply if its cross-held affiliate Company B takes a
nose-dive due to its own leverage situation. Company A’s balance sheet asset takes
a knock-on hit and deleveraging may be enforced. Remember that in financial
services and corporate treasuries assets
usually have a charge or liability against them. By putting an asset or
capital to intensive use there is less cushioning from the negative domino or
chain-reaction effects created by the weakest link in the chain.

Hence why every time there is a financial
crisis, after the horse has bolted, so to speak, Basel regulatory capital reserve requirements convene
special discussions. And After the financial crisis which unfolded in
summer 2007, regulators and bankers from 27 countries gathered yet again in
September 2010 to agree on the Basel III accord.

Evidence of a cross-holding implosion scenario: by cutting financing to hedge funds and raising ‘repo haircuts’ (basically
ransoming the fund-firms to put up more assets / collateral to back their
borrowing / leverage) prime brokers chain-reacted in the ensuing securitised
mortgage crisis of 2007.Amid systemic
crisis this credit-squeeze also caused a series of hedge fund blowups,
including Carlyle Capital, an
affiliate of the Carlyle Group! Also see the case of Anger
at Goldman Still Simmers.

Carlyle Capital Corporation, a publicly traded fund which at the time held US$21.7 bn of
securities (though it had only raised $300 mn equity through the fund IPO and
listing on Amsterdam Euronext exchange!), was served with a default notice from
one of its prime brokers after it failed to meet initial demands for just $60m
of margin calls in March 2008. This case and FPM’s database shows how hedge
fund firms and their funds can blow-up even though they have a large and
powerful affiliate. Carlyle Group which had assets of US$75 bn at the time
provided only a $150 mn credit line to the fund, which was the limits of its
exposure.

FPM reiterates a yellow-flag warning on the prospect of "distressed
domino-effect sellers" of hedge fund and manager allocations. The author
suggests a growing ‘secondaries’ in alternative manager and fund stakes. The systemic-effect concern stems from numerous
potential risk scenarios according to developments in hedge funds and the
tectonic shift in financial services, which FPM monitors as AccumulatingRisk Trends (ARTs). Some of these ARTs we follow at FPM are listed
at the foot of this article. For example, the development of buyout firms buying
stakes in the managers of hedge funds or other affiliations by varying degrees
of investment poses threats.The author of this FPM
alert experienced first-hand the UK split-capital investment trusts implosion
(British version of mutual funds with preferential and other share-classes).
Eventually these regulatory body authorised trusts, which were meant to be
safe, were investigated and fined for mis-selling despite their
hindsight-evident concomitant risks. A fiasco that ensued once cross-holdings multiplied the effect of
leverage, leading to debt covenant breaches and fund closures at the height
of a general market de-leveraging cycle of 2001-2003.

In extrapolating
split capital investment trust experience, FPM foresees a scenario of hedge
fund cross-holdings, especially between implicitly leveraged credit management
units, turning sour! A domino effect of tumbling hedge- and private equity funds
valuation, through LP-share redemptions or private market value (PMV)
deterioration in the buy-and-hold GP stakes, would shake the foundations of alternatives if Carlyle experienced
capital-flight for “whatever!” As a reminder, the tangled web-effects of
Lehman’s cross-holding and counterparty relationships are still reverberating. As
with Amaranth blow-up, long-term fund investors and GP stake-holders in it would
have ended by receiving little residual value. In FPM research-integrity, we do
not understate that Amaranth’s
demise benefited the other sides of its failed trades, in the zero sum
game.

To really get a domino-effect
or contagion from a credit hedge fund blow-up scenario, a bubble first needs to
blown. Last wave of fear was triggered in subprime mortage loans, could the next economic
impalement come from leveraged loans tied to buyout activity in
corporations souring! So noticeable that other large private-equity firms are inevitably
buying CLO funds / contracts in a bid to
capitalize on a recovery in loan prices (which we at FPM benchmark with S&P/LSTA
US Leveraged Loan 100 Index). Carlyle joins Blackstone Group via its credit-arm GSO Capital Partners, and a host
of other managers like Deerfield Capital Corporation, in acquiring investment
firms or debt funds recently. Also, in June'12, in unison with other PE
managers who have opportunistically expanded into traditional and alternative
assets, Kohlberg Kravis Roberts, one
of the oldest PE business models, purchased an existentialism-hit fund of hedge
funds player Prisma Capital Partners.
For Carlyle, this trend of PE diversification by adding alternative managers
was envisioned and initially developed in 2008. However this attempt to add
hedge funds failed when the firm liquidated a pool hurt by investments in
mortgage securities as property prices declined and credit markets froze at the
onset of the financial crisis. Highlighting such waves of consolidation in
alternatives and considering their impact is this premise of this note, and
consultancy service that FPM is embarked on.

A large credit
hedge fund blow-up may not cause economic waves but will have ripple-effects on
already dented investment portfolios at pension managers, treasuries and other
pooled financial savings. Needless to
remind industry main-stayers of the widespread panic from LTCM-collapse
ensuing from Russian debt debacle of Autumn 1998; similarly Lehman and Bear
Stearns collapse from mortgage loans should loom large in memories still! These
last two were larger interweaved entities that arguably should not have been
allowed to founder by the authorities. While those and MF Global’s bankruptcy
reach financial media headlines there are numerous others that will not be
heard-of by busy investors. Hedge funds are not only getting larger in assets
managed, but also in terms of their numbers, as the sub-text premise of this
note indicates. So it stands to reason that some AI managers will become
behemoths and others will launch with a strategic partner/s then strive to stay
afloat or destruct on stormy / rainy investment days, with or without
affiliate’s help.

One of the
earliest observation of this cross-holding, in particular via FOFs in-play-transaction
trend was in 2007 when TA Associates,
a significant specialist player in financial services transactions / deals
bought a minority stake in K2 Advisors,
which was then a UDS$5.5 bn AuM FoFs. Which had been transformed into a US$10
bn AuM firm by mid-2011. TA Associates was not only acquiring steady and
diversified revenue streams but also significant client relationships.
Relationships that FPM understand will help identify single-manager hedge funds
to be in distress or otherwise put into play as a fund manager transactions. Other
positives that FPM notes from cross-holdings, since transactions have myriad
and opaque motives would be in the
interest of acting as a cabal, coterie or cadre. For example, affiliated
M&A arbitrage hedge funds discretely cooperating can effect board changes
without breaching “ownership-percent-threshold” and triggering ‘posion pills’
(which more than 2/3rd of S&P 500 companies have as defences against
hostile takeovers).

Finally, as a self-fulfilling
flow to FMTs, we consider whether Carlyle will turn their 2011 interest in K2
Advisors fund of hedge funds into a financial or strategic buy from TA
Associate and K2 management. Deal terms and intangibles willing.

Accumulating Risk
Trends – ARTs in Alternative Investments:

Stability of repo
financing arrangements

Limits of advisor
/ management’s exposure for losses

Effectiveness of
reassurance about undrawn credit lines

Chinese wall
issues between PE and hedge fund activities

Opaqueness of leverage
levels from multiple prime broker use

Heightened government
and regulatory environment e.g.
new whistle-blower rules

Capacity
constraints on performance of larger managers and ‘style drift’

Sub-critical
mass of small to midsize management firms

Degrees of
manager connectivity in fraud, insider dealing and other breaches

Loan servicing
and refinancing difficulties in high interest rate environment